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Monday, June 28, 2010

Flat Tax?

A lot of folks are clamoring for a flat tax these days. Does it make any sense?

Flat taxers are often dismissed as kooks - along with gold-bugs, John Birchers, and other far-out political movements. Many characterize their desire for a flat tax as a way of "simplifying" the tax code and thus pooh-pooh their motivations as the desires of the ignorant - people who are too unsophisticated to understand tax credits, deductions, and depreciation or understand how to run TurboTax once a year.

But I think the point of the flat-taxers goes beyond that. Government in our country has used the tax code as both stick and carrot - to encourage people to engage in certain types of behaviors. Some may argue that these behaviors are good for the country, the economy, the environment, or the individual. Others might argue that these incentives (and dis-incentives) are also good for special interest groups.

100 years ago, if you could afford to buy a home, you paid for it on a short-term note, after putting down a substantial down payment. A surprising number of people actually owned their own homes back then, but it did require a lot of discipline to save the money to buy. Others rented, and saw nothing wrong with that.

Today, politicians tout the "American Dream of Home Ownership" as if it were the motivation behind the founding Fathers (who already owned their own homes, thank you). We provide all sorts of incentives to buy a home, from tax credits for first time home buyers to the mortgage interest deduction. We also allow rich folks (like me) to deduct mortgage interest on their vacation homes, if they have a mortgage on their vacation homes (I don't).

Is this good or bad? Like all things, it depends. Many economists would argue that when you create a tax incentive, the real effect is to raise prices. When home interest is deductible, the amount that a homeowner can pay per month goes up - and thus prices rise in a competitive market. And homeowners do this calculation when determining affordability of a home. It may cost 30% more to own than rent, but with the tax deduction, they figure it all evens out, and then hope to make something on the back-end in appreciation.

Without these tax incentives, home prices would perhaps be lower. And there's the rub - you could not remove these tax incentives overnight without causing huge disruptions in the marketplace - they would have to be phased out over 15 years or more. Frankly, the time to do this was during the big real estate boom - it may have dampened the enthusiasm somewhat. Today, even talking about such an action would cause the market to nosedive.

So the irony is, the tax code thus encourages people to borrow more - to buy their home and to buy more home. And the tax code encourages people to take equity out of their home to spend - rather than relying on consumer credit. So we have created a system of debt.

And it is not like people don't have money. No, but our tax system encourages them to put the money into stocks, not their homes, by making the 401(k) and IRA deductions so lucrative. So the average American, as I previously noted, has as much in his 401(k) as he owes on his mortgage. And the irony is, his 401(k) might be invested in mortgage-backed securities, so he is in effect loaning money to himself.

Of course, the investment bankers of America love this situation. We borrow money from them, and they collect interest and fees. Then we give them our life's savings, and they collect interest and fees. Unlike 100 years ago, where the industrious middle-class worker would put his excess savings into his home, we now have this complicated arrangement where, to chase after deductions, we put money into stocks and then borrow against our home.

The problem with this scheme is this: stocks can drop all the way to zero in value, whereas a home has at least a floor price. A worker can lose all of his retirement savings if it is in stocks and end up with nothing - and then lose his home, which is mortgaged. And all of this is because we've decided that paying off your home is a bad thing and investing in stocks is a good one.

There are numerous other incentives in the system, and they change from year to year. Tax deductions and credits are (or were) available for electric cars, diesel vehicles, hybrid cars, vehicles over 6,000GVW (as business expenses) and numerous other things, from wind power, to solar power, to whatever Congress decides what is good for us.

Is this carrot-and-stick approach to governance a good idea? Maybe. Maybe not. It causes people to engage in activities they ordinarily would not do - like build a wind farm. Are wind farms good or bad? Well, at the present time, they are uneconomical, if viewed in terms of cost per KiloWatt. We are building them only because of the tax breaks offered. In effect, we are voluntarily paying more for energy (in terms of government subsidy) than we ordinarily would, because we think it is a good thing to do.

Will this pay off in the long run? Perhaps. Perhaps eventually, the technological pump will be primed and these types of technologies will be cost-effective in their own right and people will switch to this type of power. And perhaps these projects will reduce our dependence on foreign oil and also make the environment cleaner.

Perhaps. Or perhaps like the home mortgage interest deduction, it will merely affect prices. If you build a billion-KiloWatt wind farm off the coast of Massachusetts, it will provide a lot of energy that is presently being provided by burning fossil fuels like oil, gas, and coal. As a result, demand for these fuels will go down. As we all know from school, or just basic life experience, when demand goes down, prices....plummet.

So the net effect of subsidizing these projects is to cause the prices of traditional fuels to drop, making them even more affordable (and making wind and solar even more unaffordable) which in turn means we will have to increase subsidies. Suddenly, we are in the power business and the Government is deciding which power systems are the best. Again, maybe this is a good idea or not, but let's not kid ourselves that by providing a tax incentive, all we are doing is "encouraging" activities. No, rather we are directing them.

And does this reduce our reliance on foreign oil or improve the environment? Initially, it may appear so, but again, if demand for fossil fuels decreases, then the prices drop as well. Suddenly, a "clean coal" plant is really cheap (although not really clean) and cheap gas encourages people to take a second look at that 8-liter Hummer they rejected only last year.

And that's the problem with incentives - unintended consequences. You may put in a tax incentive with the best of intentions, and have it all go horribly wrong as people try to game the system.

Take, for example, alternative fuel vehicles subsidies and vehicle depreciation rules. The former was designed to encourage people to buy alternative fuel vehicles (diesel) to get better gas mileage during a time of shortage (as if shortage wasn't enough!). The latter was designed to allow business to write-down the cost of a vehicle in a single year, provided it exceeded the 6,000 GVW rating.

The result was an orgy of buying of super-sized trucks. As one friend of mine in Arizona explained it, between the State and Federal tax credits and deductions offered, it was like getting a free truck. And the free truck was a 6,000 lb diesel Suburban or Ford Excursion.

Rather than saving the planet, we were encouraging people to rape it. Other makers followed suit - Hummer and even BMW, which introduced the X6, the first vehicle which used the IRS code as its design specification.

And increasingly, special interest groups are getting tax credits and tax deductions passed which favor their own special interests directly. Or, they get tax incentives passed that appear to favor the consumer, but in fact only encourage consumer spending in particular areas. A first-time homeowners tax credit is a fine thing, but does it help the consumer, the real estate agent, or the home builder or seller? The answer is, all three, and who lobbied for it? Certainly not the consumers.

And the problem with tax incentives is that they are like drugs. Once hooked, you can't quit, without going through painful withdrawal symptoms. As noted above, the home mortgage interest deduction could not be removed overnight without causing millions to lose their homes. Even the "first time home buyer" tax credit is proving hard to kick, as when the credit is set to expire, home sales plummet. The credit is quickly extended, of course, at the insistence of the real estate agents and builders of America.

Many folks argue that the flat-taxers are failing to realize that a truly flat tax will be a windfall to the very rich in this country, as it would lower their tax rates considerably and raise those of the working poor. This is a good argument, but it also has flaws.

To begin with, the very, very rich have ways of reducing or eliminating their tax burdens. Yes, they pay a lot of taxes, but they use every tax dodge in the book. Meanwhile, the middle class and upper middle class get socked, as they cannot afford to set up tax havens offshore, or engage in the number of other tricks used to avoid paying taxes.

Granted, the very poor pay little taxes in this country, but as such, they have little incentive to complain about taxes in general. If you pay nothing, then a new spending plan sounds like a swell idea. Tax somebody else, is the only tax plan that we can all agree on.

Our progressive tax scheme taxes you more (generally) as your income rises, until you reach a plateau where not only do your taxes drop (Social Security, Medicare) you can afford tax dodges as well, such as converting ordinary income into capital gains (see my earlier blog entry on this).

The problem with this scheme is that increasing taxes act as a disincentive to work at a certain point. If tax rates are high enough, the increased wealth from increased work, particularly for middle-class Americans, drops off precipitously as your income increases. This is, to some extent, why we do have a large middle class in this country. If you make $60,000 a year and your neighbor makes $100,000 a year, your actual spendable income may not be much different. He just pays a lot more taxes. And since he works 60-80 hours a week, he probably spends more in terms of commuting, meals, and other conveniences that allow him to work.

I have found in my personal life that this is true. Staying out of the highest bracket allows you to pay lower taxes. If you can structure your life so your "ordinary income" is low, well, you pay a lot less in taxes. And this also means that the opportunity to "make more money" is not as lucrative as it seems at first, as you don't end up making a lot more. People will turn away work, if the marginal profit from it is slim enough and the hassle is too much.

Again, unintended consequences of a tax incentive scheme. Or intended? If you offer lower taxes to people making less money, the incentive is.....to make less money. That does seem pretty simple, no?

Of course, all this debate on flat taxes is utter nonsense, as it will never pass Congress. Moreover, your Federal taxes are only a small portion of the picture and a clever way of hiding your overall tax burden. Property taxes are an increasing burden on Americans, and it is a subject that is not being talked about much. Many people are paying $5,000 to $10,000 a year in property taxes - an amount rivaling if not exceeding their Federal tax burdens. State taxes are taking an ever-increasing bite of the pie as well. And of course local sales taxes can represent 4-10% of your disposable income. This is not even counting things like staggering cigarette taxes, car taxes, and other specialized taxes.

Some have argued that you could eliminate the Federal income tax system entirely and raise money in other ways (you could even just print money and thus "tax" everyone equally through inflation). Regardless, the political will to install a flat tax system is lacking, and the disruption to the economy at this point would be severe. And since we are taxed in so many other ways, it would not have a huge impact on our overall tax bills.

Going forward, perhaps we could let some tax incentives expire and avoid creating new ones. This, I think, is where the "teabaggers" are coming from. In response to the recent recession, we instituted, in addition to a number of bailout programs, a number of tax incentives that only applied to certain groups of people or people making certain economic decisions. Cash for clunkers was a great program, if you had an old clunker and could afford a brand-new car. Usually, these are mutually exclusive groups, however.

While the intention of the program was good, the result was only that people who were in the right place at the right time could benefit from the program. Those of us who exercise fiscal restraint, and drove well-maintained older cars, for example, were not offered any kind of freebie. And that's where I think their resentment comes from.

Maybe, like a drug user hooked on crack, we need to wean ourselves of tax incentives as a means of trying to control the economy. The unintended consequences of incentives often cannot be foreseen and may cause more problems than they solve. Moreover, such incentives skew demand in the marketplace and thus do little more than skew pricing, leading to more unintended consequences.

I doubt it will happen. It is so much easier to just get another fix than to go into re-hab....